Working Papers

In this paper we examine how monetary policy should respond to nominal exchange rates in a New Keynesian open economy model that allows for a non-trivial role for sterilised intervention. The paper develops the argument against the backdrop of the evolving policy-making environment of Asian economies. Sterilised intervention can be a potent tool that offers policymakers an additional degree of freedom in maximising global welfare. We show that the gains to sterilised intervention are greater when goods market integration is low and exchange rate pass-through is high. However, increased financial internationalisation reduces the effectiveness of sterilised intervention, as the international policy trilemma becomes more relevant. Unsterilised intervention may also have a role to play, althou...

The 'International Policy Trilemma' refers to the constraint on independent monetary policy that is forced on a country which remains open to international financial markets and simultaneously pursues an exchange rate target. This paper shows that, in a global economy with open financial markets, the problem of the zero bound introduces a new dimension to the international policy trilemma. International financial market openness may render monetary policy ineffective, even within a system of fully flexible exchange rates, because shocks that lead to a 'liquidity trap' in one country are propagated through financial markets to other countries. But monetary policy effectiveness may be restored by the imposition of capital controls, which inhibit the transmission of these shocks across countr...

Recent macroeconomic experience has drawn attention to the importance of interdependence among countries through financial markets and institutions, independently of traditional trade linkages. This paper develops a model of the international transmission of shocks due to interdependent portfolio holdings among leverage-constrained investors. In our model, without leverage constraints on investment, financial integration itself has no implication for international macro co-movements. When leverage constraints bind however, the presence of these constraints in combination with diversified portfolios introduces a powerful financial transmission channel which results in a positive co-movement of production, independently of the size of international trade linkages. In addition, the paper show...

Standard models of international risk sharing with complete asset markets predict a positive association between relative consumption growth and real exchange-rate depreciation across countries. The striking lack of evidence for this link the consumption/real-exchange-rate anomaly or Backus-Smith puzzle - has prompted research on risk-sharing indicators with incomplete asset markets. That research generally implies that the association holds in forecasts, rather than realizations. Using professional forecasts for 28 countries for 1990-2008 we find no such association, thus deepening the puzzle. Independent evidence on the weak link between forecasts for consumption and real interest rates suggests that the presence of 'hand-to-mouth' consumers may help to resolve the anomaly.

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